Credit mess hits agencies in budget

Sunday

Mar 30, 2008 at 12:01 AMMar 30, 2008 at 9:26 AM

HARRISBURG, Pa. -- States, cities, hospitals and major public agencies that have been battered by wild interest-rate swings in one sector of the municipal-bond market are scrambling to refinance their debt as they add up the damage to their budgets and nurse hard feelings.

HARRISBURG, Pa. -- States, cities, hospitals and major public agencies that have been battered by wild interest-rate swings in one sector of the municipal-bond market are scrambling to refinance their debt as they add up the damage to their budgets and nurse hard feelings.

The highest-profile fallout is the tightening of the student-loan market, including the suspension of new student loans by agencies in Pennsylvania, Michigan and Iowa.

Budget makers who had planned on paying about 4 percent on borrowed funds as recently as December are searching for ways to fit rates of 5 percent to 10 percent into their budgets. Most affected institutions appear to be withstanding the tens of millions of dollars in additional costs without laying off workers or shutting down crucial services.

In Ohio, problems in the broken "auction-rate securities" bond market surfaced last month. Franklin County had to refinance out of $15 million worth of the bonds used in construction of the Huntington Park baseball stadium when their interest rate shot from 3 percent to 8 percent.

American Electric Power had the interest rates creep up on about $400 million in auction-rate bonds, a company spokeswoman said.

Duke Energy recently refinanced out of $343 million in auction-rate bonds issued through the Ohio Air Quality Development Authority, officials said. Almost $1 billion more in auction-rate bonds issued by the authority on behalf of several utilities for air-pollution-control equipment is outstanding, the authority said.

"I think it's safe to say the universe of people in auction rate are carefully examining their options," said Kate Tompkins, a lawyer with Squire, Sanders & Dempsey, which acted as bond counsel on many auction-rate deals.

KnowledgeFunding Ohio, a nonprofit issuer of student loans, said recently that it had been unsuccessful in restructuring $440 million in auction-rate bonds, and a failed auction had temporarily raised the interest rate the organization had to pay bondholders from 3 percent to 14 percent. Because of the problems, the organization might not issue new student loans this year, it said.

It is a lousy time to refinance, as many in the stampede out of the auction-rate market can attest.

The number of banks willing to lend amid the mortgage-related credit mess is shrinking, and they are being more selective about the bonds they choose to underwrite. Also shrinking is the number of bond insurers whose backing is worth the money, after most were downgraded by credit-rating agencies because of growing losses in mortgage-backed securities.

As a result, refinancing is more expensive, complicated and time-consuming.

"A year ago, we could have issued debt without a problem in a number of different markets," said Tim Guenther, the chief financial officer of Pennsylvania's student-loan agency, the second-biggest issuer of auction-rate debt in this decade. "But at this point, it seems to be almost impossible to issue debt anywhere."

For more than 20 years, investment banks promised government and nonprofit agencies that they could save money by selling auction-rate bonds. Those securities had terms of up to 30 years, but because the interest paid on them was reset at auctions every seven, 28 or 35 days, investors treated them like short-term debt, and the rates paid by issuers were lower than if they had sold plain-vanilla long-term bonds.

Buyers also benefited because their yields were slightly higher than those of money-market funds, and they were lulled into the expectation that they could easily cash out within days, when the next auction was held.

All that was based on the assumption that eager buyers would always be available in what grew to be a market of more than $300 billion.

But investors began fleeing late last year as write-downs of mortgage-backed securities increased and the backing of some bond insurers became worthless after their downgrades.

As the crunch intensified, investment banks also starting backing away from their promise to buy at auctions the bonds that no one else wanted. That caused many auctions to technically fail, triggering requirements that called for higher interest rates for a day or longer -- the Pennsylvania Housing Finance Agency paid 25 percent at one point -- and prompting a rush to refinance into fixed-rate bonds or bank-backed variable-rate bonds.

Although officials from states, cities, public authorities and nonprofit hospitals say they intend to get out of the auction-rate market even if it takes all year, the demand for safer securities has left at least one analyst concerned that lenders are in too short supply. "It's really not a good situation, and it's getting worse," said Matt Fabian, a managing director at the independent research firm Municipal Market Advisors.

To help, Fabian suggested that temporary credit relief be allowed from home-loan banks, a system of 12 quasi-public regional banks created in the Depression to ensure a stable source of funds for residential mortgages.

Legislation to that effect is being pressed in Congress by hospitals, cities and counties. It would change federal law to allow thousands of banks to guarantee tax-exempt municipal bonds. Supporters say that would free up financing for local projects such as roads and sewers that otherwise might be bogged down in tight lending markets.

Some authorities, such as the state of California and the authority that runs New York City's airports and bridges, have been able to stop some of the bleeding by swapping out for long-term fixed-rate debt. The Children's Hospital of Philadelphia took out a $170 million bridge loan to escape the auction-rate market more quickly.

Increasingly, a bigger syndicate of banks is necessary to back a new bond issue. And financial officers say they are being told by consultants not to bother sending requests for bids -- the banks are too busy to go through them all -- and instead pick up the telephone and milk personal relationships.

Amid the scramble, officials have stressed the larger savings their agencies and institutions realized over the years, but they also have raised questions about how transparent the auction-rate market was, or how well-regulated the insurers were.

Some are unhappy that investment banks continued to collect fees to operate the auctions even after dropping out of the bidding, despite what state and other public officials described as the banks' unwritten obligation to act as the bidder of last resort.

"We will keep in mind the investment banks that stood with us," said Tom Dresslar, a spokesman for California Treasurer Bill Lockyer, "and those that didn't."